1. The Banking System and the Money Supply
© 2003 South-Western/Thomson Learning

2. The property of being easily converted into cash
What Counts as Money
Liquidity
The property of being easily converted into cash

3. Liquid Assets
An asset is considered liquid if it can be converted into cash
quickly
at little cost

4. Illiquid Assets
An asset is illiquid if it can be converted into cash only:
after a delay, or
at considerable cost

5. Measuring the Money Stock
Assets and Their Liquidity
M1 and M2

6. Assets in Order of Liquidity
#1 - Cash in the Hands of the Public
#2 - Demand Deposits
#3 - Other Checkable Deposits
#4 - Travelers Checks
#5 - Savings-type Accounts
#6 - Money Market Mutual Funds
#7 - Time Deposits

7. Assets and Their Liquidity
#1 - Cash in the Hands of the Public
Currency and coins held outside of banks
#2 - Demand Deposits
Checking accounts that do not pay interest

8. Assets and Their Liquidity
Savings Type
Accounts
($2,312 billion)
Money Market
Mutual Funds
Small Time
Demand Deposits
($984 billion)
Deposits
($330 billion)
($962 billion)
Large Time +
Deposits
Cash in the
Other Checkable
($797 billion)
Hands of the
Deposits
Public
($260 billion)
($586 billion) +
Travelers Checks
($8 billion)
More
Less
Liquid
Liquid a

9. M1 and M2 M1 A standard measure of the money supply, including
cash in the hands of the public,
demand and other checking account deposits,
and travelers checks

10. M1 and M2 M2
M1 plus
savings account balances, noninstitutional money market mutual fund balances,
and small denomination time deposits

11. cash in the hands of the public +
M1 and M2
Money supply =
cash in the hands of the public +
demand deposits

12. Financial Intermediaries
The Banking System
Financial Intermediaries
Commercial Banks
A Bank’s Balance Sheet

13. Financial Intermediaries
Financial Intermediary
A business firm that specializes in brokering between savers and borrowers

14. Financial Intermediaries
Savings and Loan Associations
Mutual Savings Banks
Credit Unions
Commercial Banks

15. Commercial Banks
A commercial bank is a private corporation, owned by its stockholders, that provides services to the public.

16. The most important service is to provide checking accounts.
Commercial Banks
The most important service is to provide checking accounts.
The public holds about as much money in the form of demand deposits and other checking-type accounts as it holds in cash.

17. Commercial Banks
A bank’s profit comes mostly from lending out the funds that people deposit and charging interest on the loans.

18. A Bank’s Balance Sheet
Balance Sheet A financial statement showing assets, liabilities, and net worth at a point in time

19. A Bank’s Balance Sheet
Bond An IOU issued by a corporation or government agency when it borrows funds
Loan An IOU issued by a household or noncorporate business when it borrows funds

20. Reserves Vault cash plus balances held at the Fed
A Bank’s Balance Sheet
Reserves Vault cash plus balances held at the Fed
Required Reserves The minimum amount of reserves a bank must hold, depending on the amount of its deposit liabilities

21. Required Reserve Ratio
A Bank’s Balance Sheet
Required Reserve Ratio
The minimum fraction of checking account balances that banks must hold as reserves

22. Net Worth The difference between assets and liabilities
A Bank’s Balance Sheet
Net Worth The difference between assets and liabilities
Net worth = Total assets – Total Liabilities

23. The Federal Reserve System
The Structure of the Fed
The Federal Open Market Committee
The Functions of the Federal Reserve

24. The Federal Reserve System
Central Bank
A nation’s principal monetary authority

25. The Structure of the Fed
Chair of Board of Governors
Board of Governors
Federal Open Market Committee
12 Federal Reserve District Banks
Member Banks

26. The Structure of the Fed

27. Federal Open Market Committee (FOMC)
The FOMC
Federal Open Market Committee (FOMC)
A committee of Federal Reserve officials that establishes U.S. monetary policy

28. Functions of the Federal Reserve
Supervising and Regulating Banks
Acting as a “Bank for Banks”
Issuing Paper Currency
Check Clearing
Controlling the Money Supply

29. The interest rate the Fed charges on loans to banks
Functions of the Fed
Discount Rate
The interest rate the Fed charges on loans to banks

30. The Fed and the Money Supply
How the Fed Increases the Money Supply
The Demand Deposit Multiplier
The Fed’s Influence on the Banking System as a Whole
How the Fed Decreases the Money Supply
Some Important Provisos About the Demand Deposit Multiplier
Other Tools for Controlling the Money Supply

31. The Fed and the Money Supply
Open Market Operations
When the Fed wants to increase or decrease the money supply, it buys ro sells government bonds to bond dealers, banks, or other financial institutions, a process called open market operations.

32. How the Fed Increases the Money Supply
Excess Reserves
Reserves in excess of required reserves

33. How the Fed Increases the Money Supply
Demand deposits increase each time a bank lends out excess reserves.
In the end, demand deposits will increase by a multiple of the original dollars in reserves injected into the banking system by the open market purchase.

34. The Demand Deposit Multiplier
The number by which a change in reserves is multiplied to determine the resulting change in demand deposits
For any value of the required reserve ratio (RRR), the formula is 1/RRR.

35. The Fed’s Influence on the Banking System
After an injection of reserves, the demand deposit multiplier stops working - and the money supply stops increasing - only when all the reserves injected are being held by banks as required reserves.

36. How the Fed Decreases the Money Supply
Just as the Fed can increase the money supply by purchasing government bonds, it can also decrease the money supply by selling government bonds - an open market sale.

37. Demand Deposit Multiplier
In reality, banks often want to hold excess reserves, for a variety of reasons.

38. Other Tools for Controlling the Money Supply
Changes in the Required Reserve Ratio
Changes in the Discount Rate

39. Other Tools for Controlling the Money Supply
While other tools can affect the money supply, open market operations have two advantages: precision and accuracy.
This is why open market operations remain the Fed’s primary means of changing the money supply.